Politicians tend to like high tax rates because they believe it yields more revenue for them to redistribute. Yet the perverse incentive effects of high rates tend to limit the increase in revenue, since the higher the rates, the more worthwhile are tax avoidance activities. At some point it becomes better to consume than invest and play than work, since the rate of return is so low.
Economic Effects of High Tax Rates
High tax rates discourage work, saving and entrepreneurship. They also encourage taxpayers to rearrange their tax affairs to receive more of their compensation in less heavily taxed forms and to take greater advantage of the myriad tax preferences in today’s tax code. For example, taxpayers can reduce their tax bill by financing more of a home purchase, receiving more of their compensation as tax-free fringe benefits, or rebalancing their investment portfolios towards tax-exempt state and local government bonds.
It’s important to remember that every time a taxpayer makes a decision based on tax considerations rather than economic merit, we all lose. It wastes resources by redirecting them to less productive uses. The cost of high tax rates is not trivial. Research on the major changes in tax rates over the last several decades—the lower tax rates enacted in 1981, 1986 and 2001 or the higher tax rates enacted in 1993—finds that the behavioral responses can be large. This research generally finds that for every 1 percent decrease in the after-tax reward from earning income, taxpayers reduce their reported income by about 0.4 percent.
This does not mean that tax cuts pay for themselves. Rather, tax rate changes can have a profound effect on the size of the tax base, with lower tax rates increasing the size of the tax base and higher tax rates, such as those proposed by President Obama, shrinking the tax base. A shrinking tax base is not only suggestive of the economic costs of high tax rates, but also means that the government will take in less revenue than the casual observer might assume.
High Tax Rates Will Shrink the Federal Income Tax Base
Consider the combined effect of President Obama’s proposal to raise the top tax rate from 35 percent to 39.6 percent and the new surtax. This means high-income households will receive 54 cents rather than 65 cents from every dollar they earn; that is, the after-tax reward from earning income falls by 17 percent. Based on the research mentioned above, with such large increases in tax rates, we can expect taxpayers facing the top tax rates to reduce their reported incomes by nearly 7 percent.
What is critically important from the government’s perspective is that while it collects an extra 10 cents for every dollar subject to the higher rates, it loses over 45 cents for every dollar by which reported income falls due to taxpayers working less or otherwise reporting less income.
Overall, simulating the effect of the higher tax rates in 2011 shows that the federal government can expect to raise at most only 60 cents on the dollar. While “large” is always in the eye of the beholder, losing 40 cents on a dollar should cause us all to question this policy. Moreover, this is a cautious estimate. It is based on the behavioral response estimated for the overall taxpaying population, even though high-income households are likely to be much more responsive. Thus, we might expect an even faster shrinkage of the federal tax base from these tax increases.
President Barack Obama wants Americans to believe that they can enjoy all of his proposed programs without paying for them because “the rich” will cover the cost. Alas, this is a dangerous political fantasy. Taxing “the rich” will only be the start. To get real money, the big spenders are going to have to tax the middle class as well. There ain’t no such thing as a free lunch–or a free government program!